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Director Liability Under the Business Judgement Rule: Fact Or Fiction

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Director Liability Under the Business Judgement Rule: Fact Or Fiction SMU Law Review Volume 35 Issue 3 Article 3 1981 Director Liability under the Business Judgement Rule: Fact or Fiction Michele Healy Ubelaker Follow this and additional works at: https://scholar.smu.edu/smulr Recommended Citation Michele Healy Ubelaker, Comment, Director Liability under the Business Judgement Rule: Fact or Fiction, 35 SW L.J. 775 (1981) https://scholar.smu.edu/smulr/vol35/iss3/3 This Comment is brought to you for free and open access by the Law Journals at SMU Scholar. It has been accepted for inclusion in SMU Law Review by an authorized administrator of SMU Scholar. For more information, please visit http://digitalrepository.smu.edu. COMMENTS DIRECTOR LIABILITY UNDER THE BUSINESS JUDGMENT RULE: FACT OR FICTION? by Michele Healy Ubelaker NDER the business judgment rule a corporate director who acts in good faith and without corrupt motive will not be held liable for mistakes of business judgment that damage corporate inter- ests.' The rule represents, in part, a judicial reluctance to interfere with the internal affairs of a corporation. In Evans v. Armour & Co. 2 a federal district court articulated the rationale of the business judgment rule: [W]hen the law has occasion to inquire into [directors' activities] it is not to substitute its judgment as to whether one offer is better than another, or to resolve disagreements as to how the future business pat- tern of the corporation should proceed, but rather to determine if the directors have acted soundly and in accord with accepted business 3 practices. While this justification of the business judgment rule indicates that a director must act in the best interest of his corporation, the failure to define the parameters of the business judgment defense precisely substantially stifles any attempt to quantify the degree of care that a director owes to his corporation. The failure to confront issues of negligence and due care may reflect the considerable confusion that exists as to which functions direc- tors, particularly outside directors, must fulfill in managing corporate af- fairs.4 The lack of clarity that typifies the judicial treatment of a director's legal accountability to a corporation and its shareholders mirrors the un- 1. The concept embodied in the rule, in the words of one commentator, has been a "recurring theme that began early and has stayed late." Dyson, The Director's Liabilityfor Negligence, 40 IND. L.J. 341, 367 (1965). See Lasker v. Burks, 404 F. Supp. 1172 (S.D.N.Y. 1975); Smith v. Prattville Mfg. Co., 29 Ala. 503 (1857). See also Lewis, The Business Judg- ment Rule And Corporate Directors'Liability For Mismanagement, 22 BAYLOR L. REV. 157 (1970); Note, The Continuing Viability of the Business Judgment Rule as a Guide ForJudicial Restraint, 35 GEO. WASH. L. REV. 562 (1967); Comment, The Business Judgment Rule." A Guide To CorporateDirectors'Liability, 7 ST. Louis U.L.J. 151 (1962). Although the obliga- tions and potential liabilities of executive officers are quite often identical to those of direc- tors, this Comment addresses only the legal relationship of directors to their corporation. 2. 241 F. Supp. 705 (E.D. Pa. 1965). 3. Id at 712. 4. See notes 16-28 infra and accompanying text. SO UTHWESTERN LAW JOURNAL [Vol. 35 certainty regarding the legal responsibility of corporate directors. Conse- quently, directors act with few real guidelines to influence their office, and corporate representatives and shareholders face an uncertain result when they seek judicial redress for damages to corporate interests under allega- tions of negligent mismanagement. Occasional decisions based on federal securities law, however, suggest that directors may be held to a more clearly defined standard of conduct in their function as corporate manag- ers.5 This Comment assesses the role that the business judgment rule has played in shielding directors from legal accountability for their actions in office and suggests that the developments under federal securities law may force a resolution of the dilemma that faces shareholders and directors alike. While this Comment includes frequent references to Texas law as a point of reference, the laws of other jurisdictions also are examined. First, this Comment examines the divergence between the legal and working models of the corporate power structure. Secondly, this Comment sets forth the common law and statutory duties of directors. Thirdly, the stan- dard of conduct applicable to director conduct is explored. Fourthly, this Comment evaluates the role the business judgment rule has played in modifying this standard of conduct. Finally, the possible influence of fed- eral securities law on director conduct is examined. I. CORPORATE MANAGEMENT: THE CHANGING ROLE OF THE BOARD OF DIRECTORS The Texas Business Corporation Act provides that "[tlhe business and affairs of a corporation shall be managed by a board of directors. ' ' 6 The provision is typical of the delegation of corporate managerial function under state codes 7 and is one aspect of power distribution in both public and private corporations. The corporate power structure is viewed as a pyramid, 8 with shareholders forming the large base, the board of directors occupying a second stratum, and executive officers forming the apex. 5. See, e.g., Galefv. Alexander, 615 F.2d 51 (2d Cir. 1980); Lanza v. Drexel & Co., 479 F.2d 1277, 1311 (2d Cir. 1973) (dissenting opinion); Securities & Exchange Comm'n v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969); Escott v. BarChris Constr. Corp., 283 F. Supp. 643 (S.D.N.Y. 1968). 6. TEX. Bus. CORP. ACT ANN. art. 2.31 (Vernon 1980). 7. See ARK. STAT. ANN. § 64-301 (1947); ILL. ANN. STAT. ch. 32, § 157.33 (Smith- Hurd Supp. 1980-1981); MICH. COMP. LAWS ANN. § 450.13 (1967); MINN. STAT. ANN. § 301.28(1) (West 1969); PA. STAT. ANN. tit. 15, § 1401 (Purdon Supp. 1980-1981); TENN. CODE ANN. § 48-801 (1979). See also OHIO REV. CODE ANN. § 1701.59A (Page 1978) ("all of the authority of a corporation shall be exercised by its directors"). Some states provide that the management function shall rest in the board unless otherwise provided in the arti- cles of incorporation, in the bylaws, or by shareholder agreement. See COLO. REV. STAT. § 7-5-101 (Supp. 1979); GA. CODE ANN. § 22-701(a) (1977); KAN. STAT. ANN. § 17-6301 (1974); MASS. ANN. LAWS ch. 156, § 25 (Michie/Law. Co-op 1979); N.C. GEN. STAT. § 55- 24(a) (1975); N.J. STAT. ANN. § 14A:6-1 (West Supp. 1981-1982); WASH. REV. CODE ANN. § 23A.08.340 (1969). Other states provide that management of corporate affairs shall be by or under the direction of a board of directors. See note 29 infra. When citing to state codes, the Texas Act will be cited exclusively if it typifies other corporation codes. 8. Eisenberg, Legal Models of Management Structure in the Modern Corporation: Of- ficers, Directorsand Accountants, 63 CAL. L. REv. 375, 376 (1975). 1981] COMMENTS Shareholders elect the board of directors9 and vote on the disposition of major corporate actions.10 The board has authority by law to appoint" and remove 12 officers and to direct the affairs of the enterprise.' 3 Lastly, executives, while vested with some discretion concerning the conduct of their offices, in theory execute the policy defined by the board.' 4 Under this legal scheme the practical power to control corporate affairs stems pri- marily from the directorial level. The shareholders give general approval to board action while executives actively fulfill the directives of the board. The legal model implies that directors have an active and intimate in- volvement in the affairs of the corporation.15 In closely held corporations the characterization is fairly accurate, because considerable identity of membership exists among the three strata of the power pyramid.' 6 With respect to publicly held enterprises, however, the legal model falls short of reflecting the true power structure. The board of a public corporation ad- vises, disciplines, and responds to crisis situations but does not routinely participate in the decision-making process.I Typically, the corporation's executive officers establish working policy and manage daily activities.'8 In theory, the divergence from the legal model may be reconciled if execu- tive officers are viewed as agents of the board of directors. 19 Under this view the work of officers would be the work of the board and ratification of executive decisions by the board theoretically would fulfill the statutory mandate that the board itself manage corporate affairs.20 Such a relation- ship requires that directors monitor officer performance. The appointment 9. TEX. Bus. CORP. ACT ANN. art. 2.32 (Vernon 1980). Article 2.32 also provides that shareholders shall have the power to remove directors from the board. See ABA-ALI MODEL Bus. CORP. ACT §§ 36, 39 (1977). 10. Eisenberg, supra note 8, at 376. 11. TEX. Bus. CORP. ACT ANN. art. 2.42A (Vernon 1980). 12. Id art. 2.43. 13. See notes 6 & 7 supra and note 29 infra. The statutory directive to manage provides little guidance as to the proper function of a board in corporate life. A number of authors have attempted to identify specific activities which would come under the legal obligations of managerial functions. Harold Koontz has proposed the following functions: trusteeship, or safeguarding of corporate assets; determination of enterprise objectives; selection of exec- utives; securing long-range business stability and growth; approval of major company deci- sions; checking on results of these decisions; disposing of corporate profits and assets; and approval of mergers and acquisitions. H. KOONTZ, THE BOARD OF DIRECTORS AND EFFEC- TIVE MANAGEMENT 24-31 (1967). See also M. MACE, DIRECTORS: MYTH AND REALITY (1971).
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